Fed's Summer Blockbuster Splits Critics

THE MUCH-HYPED HOLLYWOOD HORROR FLICKSnakes on a Plane is slated to premiere this Friday. Last week Wall Street critics got a peak at a gentler drama, Doves at the Fed.

The Federal Open Market Committee met Tuesday and confirmed widespread speculation that it would keep interest rates steady -- pausing after two years and 17 increases that had lifted the federal-funds rate all the way to 5.25% from 1%. In the policy statement accompanying its announcement, the governors said overall economic growth had "moderated." While inflation outside of food and energy prices is "elevated...[those] pressures seem likely to moderate over time," owing in part to previous rate hikes, the missive said. "The extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information," the Fed added.

Some investors gave the script a thumbs-up but others thought the story was flawed.

"The Fed seems to be counting on a little bit of good luck" to contain inflation, says Drew Matus, senior economist at Lehman Brothers. Federal Reserve Chairman Ben Bernanke and his colleagues appear to believe that inflation decelerates in step with the economy, he says. "We've never seen a model" that works that way, Matus says, adding that inflation shifts lag behind economic performance.

Ouch!

In a minor subplot twist, President Jeffrey Lacker of the Federal Reserve Bank of Richmond sought a quarter- percentage-point increase in the overnight target rate, and he cast the first dissenting vote by a FOMC member in about a year. Lacker lost the battle, but many believe he'll win the war.

Lehman expects the Fed to quickly resume its credit tightening policy and raise short-term rates by 25 basis points, at its next meeting Sept. 20, and once again to 5.75% by year-end. "Not because they want to, but because they have to" to fight inflation, says Matus.

Friday's release of July retail-sales data should give pause to those hoping for an extended, well, pause. Retail sales rose by a seasonally adjusted 1.4%, the Commerce Department said, the largest monthly increase since the 3% jump in January. The median estimate of 22 economists surveyed by Dow Jones Newswires had forecast retail sales rising 0.9% in July. Excluding autos, sales were up 1.0%, double the 0.5% increase expected.

In another potentially ominous sign, import prices also rose 0.9%. During the past 12 months, import prices are up 7%, suggesting the magnitude of price pressures hitting the U.S. economy.

Investors are taking note. "We still have a defensive bias," says Jim McDonald, vice president at T. Rowe Price Group who manages more than $18 billion in taxable money markets. His first-tier money-market fund has an average maturity of about 37 to 38 days, compared with a market average of about 41 days.

T. Rowe Price expects to see the funds rate at 5.75% to 6% by year end "based on the economic data we've seen so far and what's happening with inflation," he says.

By comparison, the futures markets are pricing in about a 25% chance of another quarter-percentage-point increase at next month's FOMC meeting.

What gives?

"The Fed's looking primarily at employment numbers" in setting policy, says David Wyss, chief economist at Standard & Poor's. Given four straight tepid gains in monthly nonfarm payrolls, including July's 113,000 reported earlier in August, it was "time to pause and see what happens next," he says. The string of 17 rate increases was "the most consecutive moves they've ever made," notes Wyss.

So the August jobs report, to be offered in early September, may ultimately decide how this story plays out.

"When push comes to shove...the Fed is more concerned with accelerating inflation than slowing growth," says T. Rowe Price's McDonald. The central bankers "don't want those [inflation] expectations to become entrenched," he says.

This week inflation hawks and doves will zero in on Tuesday's producer-price index for July and Wednesday's consumer-price index -- plus industrial production and capacity utilitization -- as they try to figure out what happens next.

The importance of daily data is underlined by the Treasury market. The 10-year yield rose to 4.97% Friday, compared with 4.90% at the end of last week. The two-year rate reached 4.97%, up from 4.91% the week prior.

There was some pressure from the August refunding, which pumped $21 billion of new three-year notes, $13 billion of new 10-year notes and $10 billion of new 30-year bonds into the market.

The investment-grade corporate-bond market tackled its own flood of supply, as $17 billion of debt was priced in the two days following the FOMC's decision.

"It's a great time to issue for corporations," especially debt with 10-year maturities and longer, because the Treasury yield curve is relatively flat, says Mirko Mikelic, senior fixed-income analyst and portfolio manager at Grand Rapids, Mich.-based Fifth Third Asset Management, with $21.6 billion in total assets. Plus, almost everybody goes on vacation the last two weeks of August, he says. Or out to catch Snakes on a Plane.

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